Strategic Trading, Liquidity and Information Acquisition

Abstract

This paper studies the effects of liquidity trading on the dynamics of a financial market under long-lived asymmetric information. Informed traders maximize the expected trading gains they can extract using their superior information, whereas risk-averse liquidity traders with disparate liquidity preferences maximize their expected utility. We describe a multi-period discrete time model and find the equilibrium. We then examine the continuous time analogue of the model, find the corresponding equilibrium for a single informed trader and obtain closed-form expressions and time patterns for the operating characteristics of the market. We find that liquidity traders' reaction to informed trading impedes information dissemination to the market. When information acquisition by the insider is endogenous, we find that in contrast to models with pure noise traders, it is in the insider's best interest to curtail the amount of information he acquires. Further, the acquisition of some information by the insider makes liquidity traders better off, although at zero cost the insider acquires more information than is necessary to maximize liquidity traders' welfare. For a wide range of parameter values, the informed trader chooses to voluntarily release information to the market if he is allowed to do so. Moreover, voluntary information disclosure helps solve the problem of reduced incentives for information acquisition by inducing the informed trader to acquire full information.